Private Equity

By and February 25, 2019Financing

As your company scales, you may be looking to secure capital to propel growth or cash out your hard-earned equity. In either case, a private equity (PE) firm may be able to help you. PE firms specialize in investing in or buying out companies and ultimately liquidating their interests in the companies to achieve a handsome return. The purpose of this article is to help you understand the overall PE industry, the lifecycle of a PE fund, and the services that a PE firm can offer your company.

Industry Overview

PE can be separated into two groups: buyouts and growth equity. A buyout is when a PE firm invests in private companies on behalf of institutions or investors with the ultimate goal of either selling the acquired companies to another investor or taking the companies public. PE firms that engage in buyouts generally focus on more mature companies with stable cash flows. This is because PE firms often use a lot of debt when acquiring a company. A major part of generating a successful return is paying down this debt with cash generated by the acquired company.

PE firms may also invest a smaller equity stake (i.e., a minority stake) into earlier-stage, high-growth companies that have a proven track record of profitability. This strategy is called growth equity or growth capital. In the life cycle of a company, growth equity falls somewhere between the VC and buyout or “traditional PE” stages, though the line that separates these stages is becoming blurrier. The goal of this minority investment is to capture profits from the rapid growth of the target company. The target company benefits from this investment because it receives cash that can be used to achieve faster growth, challenge competitors, expand product lines, attract top management talent, etc.

Regardless of whether a PE firm employs a buyout or growth equity strategy, its basic internal structure remains the same. The following sections explain the organizational and fee structures of a typical PE firm.

Organizational Structure

PE firms generally operate as partnerships. The general partner (GP) is frequently the PE firm itself and has the responsibility of managing operational activities. The limited partners (LP) are passive investors that finance the PE firm’s operations. To invest in a specific PE fund as a LP, an individual or organization must meet certain qualifications1. LPs may include pension funds, insurance companies, fund of funds2, high net-worth individuals, family offices, endowments, foundations, or sovereign funds3.

After recruiting LPs to provide capital for a fund, PE firms can begin investing in companies. PE firms tend to specialize in a specific industry and/or geographic location. Sometimes, PE firms even focus on a specific asset class within an industry, such as a real estate private equity firm that specializes in multi-family units or a tech-focused PE firm that focuses on SAAS companies. PE firms invest in companies consistent with their investment strategy. The investments become part of the firm’s overall portfolio and are often referred to as portfolio companies. Periodically, the PE firm will start a new fund that invests in additional portfolio companies and is sponsored by a new set of LPs. This basic organizational structure is displayed below:

Internally, A PE firm’s hierarchy consists of analysts, associates, senior associates, vice presidents or directors, and partners or managing directors. The professionals that work at a PE firm often have investment banking experience, MBA-level education, or in-depth industry knowledge. When working with a PE firm, your company may interact with professionals at any level of the organizational hierarchy, depending on the size of the fund and complexity of the deal.

Fee Structure

PE firms make money by charging management and incentive fees. The most commonly-known fee structure is a 2 and 20 structure where the PE firm receives a 2% management fee and a 20% incentive fee.

Management fees are annual fees that a PE firm (i.e., the GP) charges its LPs. Management fees are approximately 1.5% to 2% of either committed or invested capital. Committed capital is capital that an LP commits to a fund regardless of whether the funds are used whereas invested capital refers only to funds that are actually invested in a fund. Management fees help cover the operating expenses of a PE firm (e.g., legal and accounting compliance, transaction or deal fees, salaries, rent, travel, etc.).

PE firms make most of their profits from an incentive fee or carried interest fee. After the PE firm has fully paid off the invested capital of its LPs, the PE firm generally retains about 15-20% of the profits and remits the remaining 80-85% to its LPs. However, the PE firm typically can take its portion of the profits only after it reaches a hurdle rate, which is often 7-10%. For example, if the hurdle rate is 8% with a profit split of 80:20 between the LPs and the PE firm, the LPs get all the returns until the returns exceed 8%. The next 2% is allocated to the PE firm to restore the 80:20 profit split. Any returns above 10% are then allocated according to the 80:20 split.

Thus, a PE firm that earns less than 10% in this example would earn less than its portion of the returns. The hurdle rate gives greater assurance to LPs that they will get the return they require, and it provides incentive to the PE firm to perform well. Occasionally, an agreement can have multiple hurdle rates that specify different profit splits with each layer.

Fund Lifecycle

A PE Fund typically runs for about 10 years from the time companies are purchased to the time they are sold, but the length of time can vary depending on how well the companies within each fund perform and the exit opportunities available. The major phases of the PE life cycle (outlined in the graphic below) include forming, prospecting, harvesting, extending, and exiting.

Value Creation

PE firms add value to the companies they acquire in a variety of ways, including financial and non-financial engineering methods. Financial engineering4 mainly consists of changing the capital structure of a company (i.e., recapitalization), which usually means increasing the target company’s debt to its optimal level.  Non-financial engineering methods include altering the company’s strategy or marketing, helping the target company make strategic acquisitions, or looking for ways to cut costs.

A PE firm will often acquire a company almost solely with debt through a structure called a leveraged buyout (LBO). The PE firm will then try to pay down the debt as quickly as possible using cash generated by the company, until the company reaches the optimal level of debt and equity. If a PE firm wants to squeeze out a bigger return or if an exit opportunity isn’t readily available as the harvest phase is ending, a PE firm may do a dividend recapitalization to pay off investors. A dividend recapitalization is when the target company issues new debt and uses the cash proceeds from the debt to pay back investors through dividends.

In addition to these strategies, a PE firm may add value to a company in the following ways:

  • Family succession: PE firms may buyout companies from founders that are looking to retire and liquidate the money tied up in their business.
  • Corporate carve-outs/divestitures: At the simplest level, carve-outs and divestitures refer to when a portion of a company (e.g., a business unit or multiple business units) is disposed of or sold. PE firms may buy companies that have been carved out or divested, or a PE firm may add value by carving-out/divesting certain segments of a target company.
  • Restructurings and bankruptcies: This refers to increasing a company’s value by significantly modifying its operations, structure, or systems. Often, the PE firm will help the target company decrease operating expenses and increase its operating growth rate.

Example Deals

Grab: Uber’s rival located in Southeast Asia, Grab, raised $750 million in 2016. This funding was a growth equity investment led by Softbank as part of Grab’s Series F round of funding. Softbank is a Japanese-based, multinational company that has a variety of minority, late-stage investments in the transportation, telecommunication, and technology industries.

Buffalo Wild Wings: In November 2017, Roark Capital Group committed to purchasing Buffalo Wild Wings for $2.4 billion, which was roughly a 34 percent premium to Buffalo Wild Wing’s stock value at the time of the initial bid. Roark Capital Group is a private equity group based in Atlanta, Georgia, that focuses on consumer and business service companies. Besides its new investment in Buffalo Wild Wings, Roark Capital Group has also invested in Arby’s, Jimmy John’s, Corner Bakery, and Carl’s Jr.

Pretzels Inc.: In October 2018, Peak Rock Capital acquired Pretzels, Inc. This is Peak Rock’s ninth investment in the food and beverage industry. Peak Rock focuses on middle-market companies (valued between $50 and $750 million) in North American and Europe. Specifically, Peak Rock looks to invest in companies that it can grow by improving their operations or strategy.

Conclusion

After your company passes through the VC stages, PE firms might begin looking to invest in or buyout your company. PE firms may be a great way to obtain capital for growth or give founders an intermediate pay out. PE firms specialize in investing in companies, helping their portfolio companies increase in value by using financial and non-financial engineering methods, and ultimately generating a profit for themselves and their LP investors.



 

Resources Consulted

 


 

Footnotes

  1. Often, LP investors must be “accredited investors,” which means they earn an annual income of at least $200k or meet other asset, wealth, or professional expertise requirements.
  2. A fund of funds refers to a “parent” fund that invests in other funds (e.g., mutual funds, indexes) as opposed to individual stocks or bonds.
  3. An investment fund owned by the state.
  4. In this context, financial engineering means adding value to the company by reconstructing its financial structure or procedures.
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Author Brett Bartholomew

Brett has a passion for technical accounting and hopes to be involved in the cutting technologies that are disrupting the accounting industry. Outside of accounting, Brett loves playing ultimate frisbee, golf, and basketball. Lehi, Utah, is Brett’s home town, but he has traveled throughout the U.S., Thailand, Europe, and Central America.

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